IC Top 100 Fund Rathbone Income (GB00B3Q9WG18) has been kicked out of the UK Equity Income sector after falling short of the yield requirement, just one day after the trade body said it was to consult on whether it was using the right criteria to judge income funds.
Manager Carl Stick said last week he was "frustrated" to be leaving the Equity Income sector for the UK All Companies sector after the fund failed to yield more than 10 per cent over the FTSE All-Share. It joins a raft of high-profile funds including Invesco Perpetual High Income (GB00BJ04HQ93), Schroder Income (GB00BDD2DX75), Man GLG UK Income (GB00B0117D35), and Henderson UK Equity Income & Growth (GB0007493470), which have also been ousted from the sector in recent years.
Coming just one day after the Investment Association (IA) launched a consultation into the sector's yield requirement, Mr Stick's fund's exit puts him at the centre of a contentious debate. The IA launched its consultation paper into the sector's criteria on 18 April and stated: "The requirement has attracted controversy over the years, especially in the UK Equity Income sector when high-profile funds have left the sector after failure to meet the test."
The IA is awaiting member responses on its consultation which must be submitted by 20 May.
Currently, funds are required to yield a steep premium to that of the UK market over a rolling three-year period, but with dividend cuts looming in the market and unsustainable payouts skewing the market yield, managers say they are being punished for seeking sustainable dividend payers. Mr Stick says: "The current yield offered by the FTSE All-Share is distorted by the dividends paid by a number of mega caps, yet we understand that many of these payouts are precarious.
"If we were to use yield as our primary target, we would put our own growth in distribution under some threat, and we would be taking on far too much risk for our clients."
The IA acknowledges that "a small number of major companies in the benchmark are paying higher income levels than the rest of the market, thereby seemingly pushing managers to invest in a small concentration of stocks, where dividend payouts are seen as unsustainably high."
The requirement also penalises funds that have performed well, argue critics. Laith Khalaf, senior analyst at Hargreaves Lansdown, says: "This test is currently calculated using a historic yield - taking the income produced during the year as a percentage of the price of the fund at the end of the year.
"But if a fund manager has done a good job of increasing the fund's capital, and hence its price, this has the effect of lowering the yield, and boosting the chances of the fund getting kicked out of the sector."
He adds: "The Rathbone Income fund is in our view one of the best funds in the sector. We won't be amending our analysis or view of the fund manager in light of the change in sectors, and the fund will remain on our Wealth 150 Plus list of our favourite funds available with low management charges."
Darius McDermott, managing director at Chelsea Financial Services, says dividend sustainability and performance matters more than yielding a premium to the market. "The IA has made the right decision in reviewing this," he explains. "There are now all of these income funds housed in the UK All Companies sector that don't belong there and aren't comparable.
"Expecting your income manager to at least target a market yield is sensible but a premium to that is unsustainable in the current climate. Even Neil Woodford looks likely to miss this target when his fund gets to three years old."
The three proposals put forward by the IA are:
• to make no change;
• lower the bar and require funds to yield more than the FTSE All-Share (but not by a specified amount); or
• force funds to produce more in-depth statistics.
Hargreaves Lansdown says the first and second options do not go far enough and that "most investors don't want reams of numbers thrown at them when choosing to invest. This proposal simply pushes the problem onto investors' shoulders, which simply isn't fair."
Hargreaves Lansdown suggests that the IA uses a different yield calculation based on the income produced for every £1 invested at the start of the three-year period.
Mr McDermott adds: "Rathbone Income has grown its income in 19 out of 20 years, only cutting in 2009, so if you own units in that fund your income has grown nearly every year."
However, not everybody agrees that change is necessary. Steven Bailey, fund manager in the Liontrust Macro Thematic team, says he finds the debate "unedifying. All managers operate in the same market and likely enjoy equal measures of operational freedom, so we don't necessarily subscribe to the argument that the market is at fault for missed yield objectives," he says.
